Reality Check

In a move that will certainly be welcomed by many, this is an abbreviated
holiday version of the Credit Bubble Bulletin. I think the less time spent
on stock market and economic analysis this holiday weekend, the better

Stocks enjoyed their strongest rally since early last summer, with spectacular
gains throughout the technology sector. For the week, the NASDAQ100 gained
18%, the Morgan Stanley High Tech index 15%, and the Semiconductors 23%. The
Street.com Internet index jumped 25%, and the NASDAQ Telecommunications index
17%. The Biotech index surged 15%. The Broker/Dealer index jumped 18%. Blue-chips
rallied sharply, with the Dow adding 3% and the S&P500 gaining 5%. The
Transports increased 3%, and the Morgan Stanley Cyclical index and the Utilities
rose 5%. The broader market enjoyed a solid performance, with the small cap
Russell 2000 gaining 5% and the S&P400 Mid-Cap index jumping 6%. Banks
stocks advanced about 6%. Gold stocks rallied at the end of the week, with
the HUI index posting a 3% gain. The dollar weakened into today's close and
appears vulnerable going into next week.

It was the worst week in three months for the U.S. credit market. For the
week, 2-year Treasury yields jumped 18 basis points to 4.24%. The "middle
of the curve" was hammered, with 5-year Treasury yields surging 29 basis
points to 4.76% and the 10-year 28 basis points to 5.16%. Yields on benchmark
Fannie Mae mortgage-backs rose 19 basis points and agency yields generally
surged about 26 basis points. Spreads were relatively quiet, with the 10-year
dollar swap spread about 1 basis point narrower to 89. After yesterday's key
decision by the European Central Bank not to lower rates, European bonds suffered
their worst two-day losses in five years. Importantly, global bond euphoria
has been abruptly interrupted.

The historic U.S. monetary inflation runs unabated, with broad money supply
(M3) surging another $45 billion last week. Institutional money fund assets
increased $18 billion and large time deposits added $17 billion. Over the last
two weeks, broad money supply has jumped $110 billion. M3 has increased a staggering
$600 billion during the past 35 weeks, or at a simply ridiculous annualized
growth rate of 13%. It is worth noting that commercial paper outstanding increased
$17 billion last week, with financial sector borrowings up $20 billion. Total
financial sector commercial paper borrowings ended the week at $1.153 trillion,
while domestic non-financial companies have borrowed $254 billion. This is
an acutely fragile credit system that continues to run out of control.

While investor and media attention are keenly focused on the powerful NASDAQ
rally and rising equity prices generally, it appears the past week could prove
a key inflection point for global credit markets. This is particularly the
case for what we view as a very vulnerable market in the U.S. It has been our
view, of course, that speculators have been placing aggressive bets on the
assumption that global central bankers had commenced a process of concerted
and forceful cuts. With global equity markets under intense pressure, and rhetoric
seemingly espousing virtual global economic collapse and rapidly strengthening
deflationary forces, market expectations had panic-stricken central bankers
commencing a race to near Japanese-style zero interest-rates. The problem is
that economies, while weak, are not collapsing and the evidence of general
deflation is not all too convincing. And now the markets see reluctance by
the European Central Bank to "play ball." This is not how the speculators
were hoping this would develop. In the U.S., in particular, there appears significant
market risk associated with a highly leveraged credit system in the face of
extraordinary money supply expansion, extreme financial and economic maladjustments,
and unrelenting and enormous borrowing demands.

On the international front, it is certainly worth highlighting the European
Central Bank's open disregard for intense market pressure to lower rates. This
could be viewed as a refreshing affront to the overly accommodating U.S. Federal
Reserve. If nothing else, it does draw a clear distinction to the Federal Reserve's
vice of responding impetuously to market pressures. From an article by Reuters'
Tomasz Janowski: "Duisenberg made clear the young, fiercely independent
central bank was determined to play its own game. Asked whether it mattered
to the bank that people had been asking it to cut rates, he said: 'I am polite,
so it does matter. You might say I hear but don't listen' Duisenberg stressed
that even though inflation in the 12-nation euro zone should return below the
ECB's two percent ceiling in the second half of this year, price risks, albeit
diminished, had not entirely disappeared. He said after-effects of a past surge
in oil prices and the weakness of the euro could bring higher pay demands.
'Wage developments remain an upward risk to price stability which needs to
be closely monitored,' Duisenberg said. Asked why the bank did not cut rates
if it was confident inflation would fall below two percent in the medium-term,
Duisenberg said it was not yet clear how pronounced the slowdown in inflation
was going to be."

Again parting with the Fed, Duisenberg stated 'I specifically do not want
to introduce a bias in our utterances or our statements. So you can keep on
waiting and we'll keep on seeing." Spoken like a true central banker.
And from Bloomberg: "Deutsche Bundesbank Vice President Juergen Stark
Wednesday warned against 'hectic action' and 'loose policy' in light of the
worldwide economic slowdown. In an interview with German daily Boersen-Zeitung,
Stark refrained from commenting on the next two meetings of the European Central
Bank. 'The ECB follows a price stability target and has a clear strategy,
as opposed to other important central banks in the world,' he said. 'You
can't just lump everything together and forget that interest rates in Europe
are already at relatively low levels.'"

Hats off to the ECB. Perhaps there is hope for responsible central banking
after all. Clearly, in a global environment rife with aggressive speculative
trading, central bankers should err on the side of keeping the speculating
community off balance, not pander to it like the Federal Reserve. Pandering
only nurtures speculative bubbles. It is certainly not a central bank's role
to "buddy up" with the investment community or the media, although
both groups have come to believe otherwise. From today's Financial Times: "The
surprise is not that the European Central Bank left short-term interest rates
on hold. The confusing signals meant that almost anything was possible. The
odd thing is that Wim Duisenberg, the ECB president, went out of his way to
sound hawkish." This hawkish tone is consistent with comments from former
Bundesbank President Hans Tietmeyer, including the remark "steady-hand
policy can decisively help to stabilize market expectations." Mr. Tietmeyer
also apparently made a fascinating comment to the effect that the Federal Reserve
is "dangerously near to becoming a slave to the financial markets." Near?

And while the speculators may pout and throw little tantrums in the near-term,
we certainly see recent developments consistent with the very arduous and fitful
process that over the long-term is building credibility for the ECB and the
euro. Meanwhile, the credibility of the Greenspan Fed is clearly on the wane.
We'll be the first to admit, however, that in this "mixed up world" market
participants much prefer U.S.-style aggressive "shoot from the hip and
ask questions later" central bank accommodation to the caution and measured
approach adopted by the ECB. This, like other dangerous financial market fads,
will pass. If only the speculators could create a "spread trade" taking
a short position in Fed credibility while going long ECB credibility, I think
they would have a big winner. We certainly expect such dynamics to manifest
in the currency market; it is just a matter of time.

This week provided further evidence of the significance of the mortgage-refinancings.
Bloomberg quoted a Wall Street analyst: "March was the first full month
where you could begin to see the magnitude and the power of the current refinancing
boom. Even with no further (Fed) cuts, U.S. originations should be back at
$1.5 trillion, the record we saw in 1998. If the Fed makes additional cuts,
you could see lending volumes as high as $1.7 trillion.'" From CountryWide
Credit: "'Countrywide seized the opportunity presented by the current
refinance boom, achieving three new milestones,' said Stanford L. Kurland,
chief operating officer. 'March was a landmark month for Countrywide, as we
set new company records in fundings, average daily applications and pipeline.'
Fundings were $9.6 billion in March, the highest monthly total in the company's
32-year history. The previous mark was $9.4 billion set in December 1998. Average
daily applications reached $734 million, surpassing the record set last month
by 10 percent. This enormous surge of applications pushed our pipeline of loans
in process to $18.3 billion which is also a new record and a 104 percent increase
over the same date last year." March fundings were up almost 90% year
over year.

More from Bloomberg: "Investment banks are also benefiting as sales of
mortgage-backed securities soared to the fastest pace in two years. Some $166
billion worth of mortgage bonds were sold in the first three months, the biggest
quarterly volume since the first quarter of 1999, according to Bloomberg data.
Sales of collateralized mortgage obligations reached $75 billion in the first
quarter, almost half of the total $187 billion sold in 2000. 'Everyone is really
busy,' said Thomas Marano, head of mortgage trading at Bear Stearns & Co.,
which sold about $11 billion in collateralized mortgage obligations in the
first quarter. 'I don't see this letting up for at least a few months.'"

And closely related to the mortgage finance bubble, we see the GSEs hard at
work as key players helping to recycle our massive trade deficits. From Dow
Jones: "Freddie Mac's $5 billion (bond) reopening Tuesday drew the strongest
international reception ever for a five-year reference note. Some 48% of the
deal was purchased by investors outside the U.S., easily surpassing the previous
record of 40% for a comparable Freddie Mac sale, said Louise Herrle, vice president
and treasurer." Well, I guess foreigners have to buy something with all
those dollars

I am going to highlight an article written by Gary Rosenberger at Market News
International (MNI) (www.marketnews.com). In their excellent weekly "Reality
Check" columns, they go directly to business operators to see what's really
happening below the surface of all the economic data and headlines. This week's
piece was titled "US Apartment Rent Increases Aggressive: Brokers," with
a long subheading "--Utility Increases Between 67% to 300% Major Cost-Push
--With Economy Uncertain Many See Increased Demand For Rentals --Less Apartment
Rent Inflation Where Tenants Pay Utilities."

"Apartment rents are soaring in response to skyrocketing utility bills
and a growing predilection for rental space during this period of economic
uncertainty, say brokers and management companies. That has emboldened landlords
to stand firm on rent hikes after years of hesitancy that came on competition
for a dwindling tenant population that had swarmed toward home ownership, they
say. The latest increases may typically double the percentage increases of
previous years - except in areas where tenants are responsible for their own
utility bills and there is less of a burden on landlords, they add."

Quoting an executive from an apartment management company with properties
in Ohio, Michigan and Florida: "Right now, landlords impose the most the
market can bear. Due to our costs being at an all-time high, rent increases
are aggressive. We've had horrific weather in our markets in Ohio and Michigan
this winter, and in many of our buildings we've seen the cost of utilities
go up anywhere from 67% to 300%." Further, the executive also stated "rent
increases vary dramatically by market - but on average they've been anywhere
from 5% to 10% this winter versus a norm of around 2% to 4% in recent years.
She added that some of the increase 'reflects markets that have been underpriced
and where we can no longer live with it.' Insurance, real-estate taxes, labor
and maintenance costs are up as well -- and even with the heftier rent increases
and cost-cutting measures 'we barely keep pace.' 'For years we haven't been
able to raise rents to the same degree that our costs went up. We're now playing
a little bit of catch-up.' She added she sees no evidence of an economic slowdown
in terms of an increase in the number of evictions from people who can no longer
pay rents "

"The St. Louis market has also seen rents rise amid a slower economy," from
an industry executive in Missouri. 'In our market, there is a shortage of needed
housing. At the same time, there's been a strong seasonal surge in demand for
apartment space this spring.' The combination of the two factors have forced
rents about 7% to 10% higher, compared to a normal rent increase of around
5%." She also associates the very strong market for rentals to the local
housing market. " the local real-estate market has since become so
inflated that the latest round of interest rate declines have had no appreciable
impact on the rental market. Interest rates are down, but it's still a seller's
market. There are no bargains in this market."

"In Minneapolis rent increases are in the 8% to 10% range." "In
Minneapolis, the problem is a lack of new product and vacancy rates that are
between 1% and 2% We haven't seen much development in the last four or
five years -- property tax rates of 20 cents on the dollar for rentals kept
developers out. In fact, local rent increases have been in that range for the
last three years. And rents could still go higher when landlords start to pass
on the higher cost of utilities. It's still too soon. I haven't seen them pass
it on yet, but it may still happen, " according to an apartment search
firm.

"A Los Angeles apartment locator, who asked that his name not be used,
said local rents 'are through the roof' -- stating that the local energy problems
had a hand in forcing the increases."

It just doesn't look like deflation to me, anything but. Instead, there should
be enough signs of rising prices to keep an increasingly nervous bond market
on edge. Actually, this is disturbingly reminiscent of the Japanese bubble
economy from the late 1980s. While measures of consumer price inflation remained
subdued, the true cost of living rose significantly. We follow these details
closely because credit market investors have had a very strong predilection
of looking only to data that supports their view of Federal Reserve rate cuts "as
far as the eye can see," while ignoring considerable anecdotal evidence
of heightened inflationary pressures. Hence, the marketplace is today extraordinarily
vulnerable to an abrupt change in perceptions. One of these days there may
be a Reality Check. And perhaps the ECB "sees the writing on the wall," no
longer wants to "play the game," and is instead preparing for inevitable
trouble. We think so. One thing is for sure, if U.S. rates continue to move
higher there will be a significant decrease in mortgage-refinancings, with
negative implications for financial system liquidity, consumer spending and
the Great U.S. Credit Bubble.